Loan Squeeze Thwarts Small-Business Revival

By

Mark Whitehouse

Updated March 15, 2010 12:01 a.m. ET

YPSILANTI, Mich.—
Thomas Harrison,
chief executive of Michigan Ladder Co., has a plan that would contribute to the U.S. economic recovery: Expand the 108-year-old company, adding at least 20 jobs in the process. His chances of getting the loan of $300,000 or more he needs to do so, though, depend in part on what happens to folks like home builder
James Haeussler.

Both are customers of the same community bank, the Bank of Ann Arbor. Mr. Haeussler is struggling to repay $8.3 million he and a partner borrowed to build a residential community in nearby Saline, Mich. In this economic environment, the bank doesn't want to take a chance on what it sees as a risky new loan to Mr. Harrison.

"In a world where Jim Haeussler makes it, Tom Harrison will make it," says
Timothy Marshall,
the bank's president. "But it's not prudent to do both loans at this point in time. We're in a more risk-averse mode."

Mr. Marshall's reluctance sheds light on a problem looming over the economy. A year and a half after the financial crisis hit, the U.S. credit machine is still malfunctioning. During the boom, credit was too abundant. Now the pendulum has swung. With an eye toward limiting such swings, Sen. Christopher Dodd is expected to unveil a bill Monday that would be especially tough on big banks while preserving the Fed's regulatory role, but the bill's prospects remain uncertain.

Vicious Circle

Tom Harrison wants to create jobs at his ladder company. But his chances of getting the loan he needs to do so depend in part on what happens to folks like home builder Jim Haeussler. See how their stories connect.

For a recovery to take hold, hundreds of thousands of small businesses must find the confidence to expand and create jobs. But when they get to that point, the local banks they depend on—worried about borrowers' financial strength, scrutinized by regulators and slammed by souring real-estate loans—might not be willing or able to provide the credit they need.

While big companies have been able to borrow in bond markets, smaller companies rely mainly on bank credit, which has been shrinking. In 2009, total lending by U.S. banks fell 7.4%, the steepest drop since 1942. In all, the credit pulled out of the economy by banks since the downfall of Lehman Brothers in September 2008 amounts to about $700 billion, more than double the amount so far distributed under President Barack Obama's $787 billion stimulus program.

The dearth of credit for small businesses could have a big effect on prospects for restoring the 8.4 million jobs lost since the recession began. From 1992 through the beginning of the latest recession, companies with fewer than 100 employees accounted for about 45% of net job growth, according to Labor Department data.

Policy makers have been looking for ways to reopen the spigot. President Obama has proposed creating a $30 billion fund to support small-business lending. Last month, in an unusual show of solidarity, the Federal Reserve, the Federal Deposit Insurance Corp. and other state and federal regulators issued a joint statement urging banks to continue lending to credit-worthy small enterprises.

Making sure small firms get access to credit "is crucial to avoiding a Japan-type scenario of persistent stagnation," says
Mark Gertler,
a New York University economist who has done seminal research with Fed Chairman
Ben Bernanke,
then a Princeton University professor, on how troubles with bank lending can aggravate economic downturns.

Getting banks to lend more won't be easy, given the rising tide of defaults on loans made to finance housing developments, office buildings, shopping malls and other commercial real estate.
Deutsche Bank
expects banks to suffer at least $250 billion in losses on such loans, with about half coming in the next few years. Together with an estimated $250 billion in further charge-offs on home mortgages, that's more than double banks' current reserves against losses on all types of loans.

The stakes are particularly high for community banks, which tend to be much more active in commercial real estate than their larger counterparts. As of December 2009, such loans comprised about 42% of all loans held by the 7,344 banks with less than $1 billion in assets, compared to about 17% for the hundred or so banks with more than $10 billion in assets.

Some bankers say policy makers' desire to encourage lending isn't always reflected on the ground, where they say bank inspectors are getting tougher about lending standards. "For the first time in my 37 years in banking, we're having to say to our clients that we're not sure this will pass muster with the regulators," says
Larry Barbour,
president and chief executive of North State Bank in Raleigh, N.C. "That's not healthy."

Washtenaw County, Mich., which includes Ann Arbor, Ypsilanti and Saline, offers a glimpse of how the cycle of economic malaise and shrinking credit is playing out across the country. The county includes the Willow Run plant, where Ford Motor Co. once produced the B-24 Liberator bombers that helped win World War II, the University of Michigan football stadium, and hospital complexes and high-tech start-ups in Ann Arbor. As of December, Washtenaw's unemployment rate stood at 9%, close to the national average.

Michigan Ladder's Mr. Harrison, 44 years old, remembers vividly the day in September 2008 when the recession hit home. The company, which manufactures wooden ladders and distributes imported aluminum and fiberglass models, had been doing well despite the financial crisis. Sales were up 6% over the previous year, and Mr. Harrison had expanded the company's staff to about 28, from 20 at the beginning of the year.

But during the week of Sept. 15, the company's largest supplier of aluminum and fiberglass ladders suddenly refused to deliver ladders unless it was paid in advance. Within days, says Mr. Harrison, Michigan Ladder lost as much as $1 million of the supplier credit on which it relied to pay for raw materials and maintain its inventory of ladders. At the same time, its customers started failing to pay for ladders it had already delivered.

"Literally overnight, the whole world changed for us," says Mr. Harrison. "It was simply too much of a shock—too much of a change, too quickly." He laid off eight workers in December 2008 and another eight in 2009 as sales fell 40%.

Mr. Harrison has since lined up new credit from suppliers, and he says sales are on track to rise 15% this year. He thinks the time has come to implement the expansion project he shelved when the crisis hit. The plan: Produce in Michigan the aluminum and fiberglass ladders he currently imports from places such as Mexico and China. He already has the customers, and he calculates that manufacturing in Michigan will actually boost his profit margins, in part because the savings on shipping will offset the higher cost of U.S. labor.

"We can do this," he says. "We can be a low-cost producer, and we will have a made-in-USA product, which we think will have some appeal to people."

The Bank of Ann Arbor is Mr. Harrison's best bet to finance his project. Larger banks typically don't deal with companies the size of Michigan Ladder. Also, Bank of Ann Arbor, which has $543 million in assets, has weathered the crisis much better than most of its peers. It turned profits every year, expanded overall lending and declined the support of the government Troubled Asset Relief Program.

The bank has made loans to finance expansions for some of its stronger customers, such as Solohill Engineering, which makes products used in the manufacture of vaccines and more than doubled sales in 2009. Nonetheless, says its president, Mr. Marshall, fears about a weak recovery are prompting even healthy banks to be careful, a trend he recognizes could help make those fears a reality.

"It's kind of a vicious cycle," he says. "Anytime you're in an economic environment like we are, bankers are going to be more conservative."

One of bankers' main concerns is the damage the recession has done to many companies' finances. Values of real estate and other things small business owners can put up as collateral for loans have fallen so far, so fast, that many businesses have little to offer. Also, a year or more of losses have eroded the value of owners' stakes in companies, leaving less of a cushion against bankruptcy.

Mr. Marshall says such financial concerns are a big reason he's not ready to lend to Mr. Harrison, who says his company took heavy losses in 2008 before returning to profitability in 2009. Mr. Harrison says he's exploring ways to raise new money from investors, but so far to no avail. "It's not reasonable to expect that [the Bank of Ann Arbor] can make up for all the credit companies like ours have lost," he says.

Mr. Harrison's credit difficulties also are linked to the travails of other borrowers such as Mr. Haeussler, the 51-year-old president of Peters Building. In 2005, he and a partner began developing a 625-acre piece of land known as Saline Valley Farms, the site of a cooperative farm in the mid-1900s.

The downturn hit Mr. Haeussler hard in 2007, when home builder
Toll Brothers
called with bad news: It wouldn't exercise its option to purchase 93 luxury-home lots, the entire first phase of the Saline Valley Farms project. When the $8.3 million loan he and a partner had taken out to grade the lots and build infrastructure came due in late 2008, they still owed $6.7 million and had 76 empty lots, the estimated value of which had fallen to about $1.4 million.

"It was perfectly wrong timing," says Mr. Haeussler.

Losses on loans to developers such as Mr. Haeussler have taken a toll on community banks, eroding their capital and limiting their capacity to make new loans. Bank of Ann Arbor has moved more quickly than other banks to recognize losses, charging off nearly one-quarter of its construction and development loans in 2009. That compares to about 5% for all banks. In its remaining portfolio of such loans, about 6% are delinquent, compared to about 16% for all banks.

Many community banks are renegotiating troubled real-estate loans. In Mr. Haeussler's case, the Bank of Ann Arbor cut a deal: In return for a four-year extension, Mr. Haeussler and his partner more than quadrupled the amount of collateral backing the loan, putting up the entire Saline Valley Farms project and more. Even with the added collateral, the bank charged off $2.1 million of the loan, effectively recognizing that it may never get the money back.

The bank figures that giving Mr. Haeussler more time increases the odds he will pay off his loan. But such deals tie up cash on what essentially are bets that existing borrowers will make it through. That leaves banks, including Bank of Ann Arbor, with less appetite to make new loans to customers like Mr. Harrison, who doesn't have the resources Mr. Haeussler and his partner used to secure their loan.

Mr. Haeussler, for his part, says he's trying not to think too much about all that's hanging in the balance, which could include his entire business. "It's a little unnerving at times," he says. "But you just have to put your head down and work through it."

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